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A 'Don't Fight the Fed' Yield Curve Update

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Here are some insights into spread trading strategies and how to read spread charts, especially as related to the Fed's zero interest rate policy.

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In this article I want to circle back to one of my previous posts on analyzing yield curves and offer up a few insights into spread trading strategies and reading spread charts. I will also highlight my approach to trading spread curve steepening. In my initial article on yield curves, I highlighted how the US Federal Reserve has married itself to ZIRP (zero interest rate policy) until death do them part by anchoring short-term interest rates at zero. And this has lowered the probability of seeing nominal yield curve inversion to a range of slim to none… and slim just left the building. So what does this have to do with spread trading? Well, let's do a quick yield curve update before offering some spread trading education.

"Don't Fight the Fed" Yield Curve Update

The Fed recently said it would probably keep interest rates at virtually zero into 2015. By leaving their purchases "open-ended" and extending guidance, the Fed seems to be risking a steeper yield curve. This steepening would signal more inflation risk and also reflect a negative outlook on the prospect for a "recovery." It is my opinion that when the FED eventually loses control of the curve the long end will be the first to slip through its fingers.

I fully believe that the Federal Reserve will continue to flood the system with QE to infinity in its feeble attempt to get the stimulus depended economy back on the dance floor.

In the meantime, it is a wonder to me that we don't see much use of the word stagflation in the media, even though it's pretty clear to me that the "jobs" are not coming back (Stag-). Charles Hugh Smith explains why here in a good read.

And Inflation is clearly starting to wreak havoc on the cost of living (-Flation)

Since the only two certainties in life are death and taxes, eventually the weakening of the US currency in real terms will cause the Japanese and Chinese central banks to stop purchasing US Treasuries. And it is my opinion that this will drive the price of 10-year and 30-year bonds down faster than the 2- and 5-year bonds. To take advantage of this speculation, one such strategy that I look at is a yield curve steepener spread. Before I discuss this type of trade in any detail, I want to offer a little crash course in spread trading.

Spread Trading Basics

Some of my closest cohorts have managed very large portfolios that are entirely built on differing spread trading strategies, so I thought a little spread trading primer would be interesting for everybody.

The featured yield curve spread is between two like interest rate contracts under different months; this is often referred to as an intra-commodity spread. As well, there are endless types of inter-commodity spreads that I track and analyze. These are spreads between two or more different commodities.

Some of the spreads I follow include:
  1. Brent vs. Crude
  2. Crack Spread (The Widow Maker)
  3. Crush Spread
  4. Russell (INDEXRUSSELL:RUT), Dow Jones Industrial Average (INDEXDJX:.DJI), S&P 500 (INDEXSP:.INX) matrix (i.e. index arbitrage).
  5. Gold, Silver, Platinum
  6. Eurodollar Calendars and Butterflies
  7. CBOE VIX (^VIX) term structure "calendar spreads"
Some advantages of spread trading:
  • Often allows traders to assume less risk than an outright position
  • Margin requirements are often substantially lower
  • Correlation and mean reversion strategies often outperform during consolidative market conditions
  • Decreases "directionality" risk
Some disadvantages of spread trading:
  • Automatic stops are typically not available. And, if they are, they are not cheap
  • Twice the commissions
  • No guarantees that the spread will "mean revert." Even highly correlated markets often "blowout" in times of irrational expectations.
Spread Analysis

Since directional expectation of the underlying is often not the primary motive in spread analysis, more investigations into correlations, mean reversions and seasonality are often implemented. To take advantage of statistical relationships, I often look for spreads that are currently at extreme readings in terms of their normalized distribution curves (see graph below). And similar to the techniques in any market profile, I look for some form of a reversion to the mean. Unfortunately, the tools to do this analysis are not regularly available other than on Bloomberg terminals or other custom fancy excel spreadsheets.
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No positions in stocks mentioned.
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